Friday, January 09, 2009

Fama & French on Debt Overhang

I recommend this piece by U Chicago's Fama and French on what debt overhang is, and what different kinds of bailouts mean. In particular, it shows how taking a balance sheet approach is critical to understanding this financial crises.

A severe fall in the market value of a financial institution's assets raises the risk and lowers the market value of its debt, as well as its equity. Bringing in new equity capital produces an equal (dollar for dollar) increase in the market value of assets. This lowers the risk and raises the market value of the institution's debt. As a result, part of the new equity capital shows up not as equity but as a transfer to debt holders. (This is the debt overhang problem.) Who pays for the transfer? Not the new private stockholders. They will not invest unless they get stock with market value at least equal to the funds they provide. This means the transfer of wealth to the old debt holders must come from the old stockholders. They pay via the dilution of their ownership share (and the drop in the share price) caused by bringing in new equity. (The stockholders, of course, hate this transfer to debt holders.)

If the market value of the old stock before the equity issue is low, it may be insufficient to cover the transfer of wealth to debt holders that new equity capital produces. As a result, the market value of a stock issue would be less than the funds provided, and the financial institution's attempt to issue equity to meet its capital requirement will fail.

If the Treasury steps in when the private market refuses to provide equity capital to a financial institution, we are in subsidy land. Again, the subsidy arises because a large part of the equity injection by the government does not end up as government (taxpayer) equity but rather goes to prop up the financial institution's debt holders.

The key here is that, so long as the debt holders are first in line to claim the firm's assets, any infusion of capital will pay them, and not recapitalize the bank. Banks cannot be recapitalized until the debt overhang is written off. Undercapitalized banks do not make loans.